GLOBAL POLITICAL RISK The New Convergence Between Geopolitical and Vox Populi Risks, and Why It Matters Citi GPS: Global Perspectives & Solutions January 2016 Citi is one of the world’s largest financial institutions, operating in all major established and emerging markets. Across these world markets, our employees conduct an ongoing multi-disciplinary global conversation – accessing information, analyzing data, developing insights, and formulating advice for our clients. As our premier thought-leadership product, Citi GPS is designed to help our clients navigate the global economy’s most demanding challenges, identify future themes and trends, and help our clients profit in a fast-changing and interconnected world. Citi GPS accesses the best elements of our global conversation and harvests the thought leadership of a wide range of senior professionals across our firm. This is not a research report and does not constitute advice on investments or a solicitation to buy or sell any financial instrument. For more information on Citi GPS, please visit our website at www.citi.com/citigps. Citi GPS: Global Perspectives & Solutions January 2016 Tina M Fordham is Managing Director and Chief Global Political Analyst at Citi, the first to hold this position. Named in the Top 100 Most Influential Women in Finance and "40 Women to Watch", she joined Citi in 2003, where she advises corporate boards and institutional investors on the implications of macro political developments. Her work focuses on hard-to-quantify risks such as geopolitics and socioeconomic factors, including Vox Populi risk, the idea that public opinion is a risk factor in the investment environment, as well as the role of women in the global economy. Previously, she served as senior advisor in the UK Prime Minister's Strategy Unit and head of global political risk at Eurasia Group, where she started the firm's financial markets research business. Fordham is a member of the Corporate and Investment Bank Diversity Board and the Veteran's Network at Citi, and sits on the International Advisory Council for the foreign policy think tank Carnegie Europe. A fellow of the Aspen Institute's Socrates Society for emerging leaders, she is a frequent commentator on the BBC, CNN, CNBC and Bloomberg. Fordham earned her master's degree in international affairs at Columbia University. She is a San Francisco Bay Area native, and lives in London with her two daughters. +44-20-7986-9860 | [email protected] Jan Techau is the director, the European think tank of the Carnegie Endowment for International Peace. Techau works in EU integration and foreign policy, transatlantic affairs, and German foreign and security policy. Before joining Carnegie in March 2011, Techau served in the NATO Defense College’s Research Division from February 2010 until February 2011. He was director of the Alfred von Oppenheimer Center for European Policy Studies at the German Council on Foreign Relations in berlin between 2006 and 2010, and from 2001 to 2006 he served at the German Ministry of Defence’s Press and Information Department. Techau is an associate scholar at the Center for European Policy Analysis and an associate fellow at both the German Council on Foreign Relations and the American Institute for Contemporary German Studies. He is a regular contributor to German and international news media and writes a weekly column for Judy Dempsey’s Strategic Europe blog. Ebrahim Rahbari Edward L Morse Global Economist Global Head of Commodities Research +1-212-816-5081 | [email protected] +1-212-723-3871 | [email protected] Seth M Kleinman Michael Saunders Head of Energy Strategy Head of West European Economics +44-20-7986-4556 | [email protected] +44-20-7986-3299 | [email protected] Tiia Lehto Political Analysis Associate +44-20-7986-4460 | [email protected] January 2016 Citi GPS: Global Perspectives & Solutions 3 GLOBAL POLITICAL RISK The New Convergence Between Geopolitical and Vox Populi Risks, and Why It Matters Mark Schofield 2016 has begun, as 2015 ended, amid a significant worsening of the global political Global Macro & Strategy Group climate and along with that, considerable volatility in financial markets. Investors and businesses are increasingly aware of the need to understand the drivers and the implications of a greater level of event risk exacerbated by shifting social patterns. Tina Fordham, Citi's Global Chief Political Analyst, has already warned that the latest events may mark a turning point in the political landscape as rising geopolitical tensions and shifting socio-political trends converge in an increasingly interconnected world. In this publication, Tina and co-author Jan Techau, Director of European think tank Carnegie Europe, explain how weakened global elites and fast evolving social trends have created an increasingly unstable political environment that threatens to bring unprecedented commercial challenges on a global scale. There is an increasing likelihood that new transmission mechanisms are evolving that could lead to political risk having an impact on economic forecasting models, changing the way that companies do business and driving a secular, or even structural, increase in risk premia in financial markets. Until now, financial markets have taken a relatively sanguine view of political events, treating them as regionalized and idiosyncratic. However political risk can quickly and meaningfully alter return expectations across asset markets where transmission mechanisms are established in economic channels. Political events and social trends are becoming increasingly interconnected; links can easily be made between tensions in the Middle East, terrorist attacks around the world and the migration crisis, between migration and European politics, and between tensions in Europe and politics in the UK. With shifting political sands in the US creating a vacuum in global governance, there is an increasing risk that a negative feedback loop is forming as previously comfortable sectors of society feel increasingly vulnerable and less financially secure. Hitherto, geopolitical events have largely been addressed through diplomatic channels but, as Tina and Jan point out, diplomacy is ineffective against a rising sentiment of injustice and inequality among increasingly diverse social groupings. The result is an increased incidence, on one side, of non-diplomatic measures such as sanctions, protectionism, aggressive regulation, border disputes and armed conflict, and on the other of anti-establishment sentiment, protests, violent demonstration and terrorist activity. All of these can deliver a direct economic cost that could be changing the business and investment landscape. There are several channels through which political events could become a driver of financial markets: Sharply higher or lower commodity prices are surely one. Sanctions are another as they will normally have an impact on the economic prospects of an affected country. There may be an offset to this; when exports from a sanctioned country fall, there is likely to be a substitution effect in another producing economy. Overall, however, a combination of more sanctions and increased protectionism is likely to result in lower levels of trade and this, with reduced comparative advantages in production, is likely to weigh on global growth and commerce. © 2016 Citigroup 4 Citi GPS: Global Perspectives & Solutions January 2016 One of the main factors insulating markets from geopolitical risk has been abundant liquidity provision by central banks. As the Fed begins to raise rates, that support will begin to wane. For most of 2015 markets were transfixed by two main drivers; Fed policy and China's economic outlook. 2016 and beyond may prove to be the era in which politics rather than economics comes to the fore. To address this, we have brought together leading experts on geopolitical and socio-economic risks (Tina Fordham and Jan Techau) energy (Ed Morse) and economics (Ebrahim Rahbari) who believe the contours of a new post-Cold War, post-Lehman paradigm are emerging. If they are right, or even partly right, and these changes are structural, we may be entering a new paradigm, where policy-makers, including Central Banks, have less power to mitigate risks. This suggests a whole host of previously assured assumptions could be in the process of becoming obsolete. © 2016 Citigroup January 2016 Citi GPS: Global Perspectives & Solutions 5 Contents Is This the Dawning of a New Era? 9 About This Report 12 Intersecting Risks Mark a Change in Trend 14 The Geopolitical Backdrop 17 Power Sclerosis Post-Pax Americana 17 Geopolitical Risks on the Rise 22 Vox Populi Risks Continue, and Evolve 32 Two Key Political Signposts for 2016: US Elections and the UK EU Referendum 45 2016 and Beyond: Four Hotspots Where Geopolitics and Vox Populi Risk Are Most Likely to Converge 52 1. EU at Risk 52 2. Ongoing Middle East Disruption 57 3. Asia Pressures Intensifying 60 4. The New Geopolitics of Energy — Round One 61 Wild Cards 66 Silver Linings 68 Conclusion 70 © 2016 Citigroup The world has become a more dangerous place Will old and new risks converge? Only 43% Non-mainstream of US aggregate More referenda/ income went to middle class political parties gaining 6/27 households constitutional crises support, winning countries with trust during 2014 in systemically- over 10% in institutions Down from . significant of greater than 60%. 72% overall votes in in 1970. countries. 11/16 key elections. 1970 2014 “NEW” Socio-economic